Can the Student Debt Crisis Outshine the Housing Bubble?

NEW YORK (MainStreet) —It is a crisis looming on the horizon. Indeed, the possibility of massive defaults of student loans may be this decade’s financial crisis. Some say it would rival the housing bubble and the dot.com bubble in terms of its effect on the national economy.

That's a major fear for Lindsey Burke, the Will Skillman Fellow in Education Policy at the Heritage Foundation in Washington, D.C. Student loan debt now exceeds credit card debt, and too often, students are financing degrees that don’t pay off in the long run.

Burke also noted that online courses are putting tremendous pressure on the traditional university system. Access to information is becoming radically cheaper, while the cost of college continues to increase at unsustainable rates. She said this will cause the bubble to burst.

But not everyone is ready to sound the alarm. Neal P. McCluskey, the Associate Director, Center for Educational Freedom at the Cato Institute, Washington D.C. feels there's much ado about nothing and minimized the danger of the potential economic drain.

“I’m not sure that there is good evidence that this decade’s financial crisis will be huge defaults on college loans," McCluskey said.

McCluskey believes that it costs far too much to attend college. He attributes this, in large part, to the federal student aid that enables colleges to increase their tuition rates in excess of the inflation rate.

“But average debt for graduates with debt is around $27,000, which is small compared to mortgage debt," McCluskey said. "For students going to good schools and pursuing in-demand degrees, it should not be hard to pay off.”

According to McCluskey, the student debt issue pales in comparison to the mortgage bubble. The amount owed is not nearly what was owed in mortgages and defaults will not have the economic effect.

But that opinion does not withstand close scrutiny. There are a few reasons why:

First, the data on student debt is not extensive. The figures used to calculate the average student debt comprise only about half of the universities which self-report the data.

The amount does not include money borrowed in forms other than student loans.

The comparison to housing is invalid. Unlike the housing bubble student loans are difficult to discharge in bankruptcy and student loans are unsecured.

Are We Underestimating Student Debt?

Richard Vedder, an economics professor emeritus at Ohio University and author of Going Broke By Degree (Aei Press, 2004), believes that the data, which some use to minimize the issue of student debt, is far from comprehensive and not necessarily interpreted correctly.

“The amount of outstanding debt may be more than we think,” Vedder said. “I do think the loan problem rather than being overplayed may be underplayed.”

Vedder mentioned that there are a lot of people whose debt exceeds the average. Also, a lot of college graduates never earn the average or, if they do, it will not be until several years after graduating from college.

“If a college student takes a $25,000-a-year job, as many are, the debt to income ratio is very high,” Vedder said. “So these people are hurting.

Much of the student debt was in a form other than student loans, according to Vedder. Many parents, he believes, are subsidizing their kids’ education and not getting student loans.

“A second mortgage may be taken on a house that has nothing to do with education but in reality is used for college,” Vedder said.

The current student loan default rate – within three years - is 13%, Veder said. The proportion of student borrowers who are 90 days or more in arrears is even greater than 13%.

FICO Labs, which produces the FICO Score — “the standard measure of consumer credit risk in the United States” – researched the amount of student loan debt and arrived at figures that were even more dire than Vedder’s.

According to FICO, “as a group, individuals taking out student loans today pose a significantly greater risk of default than those who took out student loans just a few years ago. The situation is compounded by significant growth in the amount of debt that new graduates are carrying.”

FICO said the delinquency rate, from 2005 to 2007, on student loans that were originated in the three months after October 2005, was 12.4%. The comparable figure from 2010 to 2012 is 15.1%. This represents an increase in the delinquency rate by nearly 22%.

FICO also said that with the delinquency rate is climbing, the average amount of student loan debt is increasing even faster; the average U.S. student loan debt was $17,233 in 2005. By 2012 it increased to the aforementioned $27,000. This was a hike of 58% in seven years.

This was very different from credit card balances and car loans, which actually decreased during the same period. Also FICO learned in its December 2012 quarterly survey of bank risk managers, almost 60% of respondents expected student loan delinquencies to increase over the next six months.

According to Vedder the basic problem now is the same as it was in the late 1970s - when the government began increasing collection of defaulted student loans. The numbers are a lot larger now than they were then, though. And the magnitude of of outstanding indebtedness is also increasing at an ever rapid pace.

Outstanding student debt was $250 billion in 2003. Now Now it is about $1 trillion.

“This means that after allowing for inflation the amount of student debt is doubling every seven years” said Vedder. “It is not sustainable. It might be sustainable for one more seven year period. But beyond that – say at $4 trillion - the nation would not be able to sustain such a debt burden.”

Is this the Tipping Point?

The Obama administration has recognized the problem and made it a campaign issue.

U.S. Department of Education spokesperson Jane Glickman said, “President Obama has made college affordability and transparency around college costs a benchmark of its education agenda.”

According to Glickman, the administration worked diligently to ensure that the Congress took action to prevent student loan interests from doubling last July and also enacted the Pay-as-You-Earn option, an outgrowth of the Income Based Repayment (IBR) plan, which both aim to keep interest payments low and are based on income and family size.

The IBR, placed into effect in 2009, was changed in 2010 to great fanfare by the Obama administration. Education Secretary Arne Duncan emphasized the commitment “to making college affordable and accessible."

Duncan maintained that college remains an excellent investment, but he acknowledged that high student debts “may make it difficult for borrowers to weather hard times or to choose public service careers.” New regulations were implemented to expand eligibility for IBR. Borrowers who initially could not enroll in IBR because of their initial debt size became eligible based on increased debt with accrued interest. The "marriage penalty,” which calculated the total debt of married couples for IBR eligibility purposes was also eliminated. The program will be further expanded in 2014.

“We have also produced several consumer tools to help students and families assess the quality and affordability of colleges and universities so that, as President Obama said in his latest State of the Union address, they can get the most bang for their buck,” said Glickman. “The newest one is the College Scorecard. Another is the financial aid Shopping Sheet.”

Glickman stated that the Obama administration is ensuring students have affordable loan repayment options and prevent defaults.

“They also want to make sure students and families, at the front end, have the information they need to make astute choices when thinking about college,” she said.

But people like Vedder remain cautious. There are not many options for those who are in their twenties and thirties who already incurred loans and are trying to figure out how to repay them, Vedder observed.

“Some people have proposed forgiving the debt,” said Vedder. “But I am inalterably opposed to this. The taxpayer will not be able to absorb a trillion dollar debt.”

The fact is - despite the denial by some - college student indebtedness is an ominous financial crisis. It is one that – unless there is a solution – threatens lower the standard of living of all Americans. College graduates, many of whom are underemployed, will not be able to repay their loans without some kind of forgiveness or assistance. In that case the American taxpayer, who bailed out Wall Street and Detroit, will be called on to bail out the Ivory Tower. If this happens it might be the proverbial straw for the American economy.

“Clearly we are in a tipping point and there will be repercussions,” he said.